The Plaza Accord: The World Intervenes In Currency Markets

The historic 1985 Plaza Accord, signed at the Plaza Hotel in New York City, was a pro-growth agreement signed by what was then known as the G-5 nations: West Germany, France, the United States, Japan and the United Kingdom. The purpose was to force the United States to devalue its currency due to a current account deficit approaching an estimated 3% of GDP according to Paragraph 6 of the accords. More importantly, the European nations and Japan were experiencing enormous current account surpluses as well as negative GDP growth, threatening external trade and GDP growth in their home nations.

Protectionist measures to guard these gains were looming, especially in the United States. Developing nations were in debt and not able to participate in positive trade or positive growth in their home nations, and the United States was forced to realign the exchange rate system due to present imbalances and to promote growth around the world at the expense of its own nation. The Plaza Accord was a growth transfer policy for Europe and Japan that was wholly detrimental to the United States.

Trading Hits a Protectionist WallThe United States experienced 3% GDP growth during 1983 and 1984 with a current account deficit approaching an estimated 3-3.5% of GDP, while European nations saw a negative GDP growth of -0.7% with huge trade surpluses. The same thing happened to Japan. Trade deficits in general require foreign financing. For the United States during the early to mid '80s, Japan and West Germany were buying United States bonds, notes and bills from their surpluses to finance our current deficits at the expense of their own economies. It was only a matter of time before protectionist policies entered this equation that would not only hurt United States growth at home but force trade wars that would derail the entire system of trade for all nations. (To learn more, check out What Is GDP And Why Is It So Important?)

During this period, inflation was the lowest it has been in 20 years for all nations, and European nations and Japan were investing in their own economies to promote growth. With low inflation and low interest rates, the repayment of debt would be accomplished quite easily. The only aspect missing from these equations was an adjustment in exchange rates rather than an overhaul of the present system.

Global CooperationSo the world cooperated for the first time by agreeing to revalue the exchange rate system over a two-year period by each nation's central bank intervening in the currency markets. Target rates were agreed to. The United States experienced about a 50% decline in their currency while West Germany, France, the U.K. and Japan saw 50% appreciations. The Japanese yen in September 1985 went from 242 USD/JPY (yen per dollar) to 153 in 1986, a doubling in value for the yen. By 1988, USD/JPY exchange rate was 120. The same thing happened with the German Deutsch mark, French franc and British pound. These revaluations would naturally benefit developing nations such as Korea and Thailand, as well as leading South American nations like Brazil because trade would again flow. (For more, see Forex Currencies: The USD/JPY.)

What gave the Plaza Accord its historic importance was a multitude of firsts. It was the first time central bankers agreed to intervene in the currency markets, the first time the world set target rates, the first time for globalization of economies and the first time each nation agreed to adjust its own economies. Sovereignty was exchanged for globalization.

For example, Germany agreed to tax cuts, the U.K. agreed to reduce its public expenditure and transfer monies to the private sector, while Japan agreed to open its markets to trade, liberalize its internal markets and manage its economy by a true yen exchange rate. All agreed to increase employment. The United States, bearing the brunt of growth, only agreed to devalue its currency. The cooperative aspects of the Plaza Accord were the most important first.

Currency Value - What Does It Mean?What the Plaza Accord meant for the United States was a devalued currency. United States manufacturers would again become profitable due to favorable exchange rates abroad, an export regimen that became quite profitable. A high U.S. dollar means American producers can't compete at home with cheap imports coming from Japan and European nations because those imports are much cheaper than what American manufacturers can sell according to their profitability arrangements.

An undervalued currency means those same imports would experience higher prices in the United States due to unfavorable exchange rates. What a high dollar means for the United States is low inflation and low interest rates that benefit consumers because they have enough dollars to far exceed prices paid for goods. What the United States agreed to was a transfer of a part of its GDP to Europe and Japan so those economies would experience growth again. And all this was accomplished without fiscal stimulus - only an adjustment of exchange rates. What is understood in the modern day are the harsh effects such devaluations may have on an economy. (For more, see our Inflation Tutorial.)Japan Feels the EffectsThe Japanese felt the worst effects in the longer run of its signing of the Plaza Accord. Cheaper money for the Japanese meant easier access to money along with the Bank of Japan's adoption of cheap money policies such as a lower interest rate, a credit expansion and Japanese companies that moved offshore. The Japanese would later become the world's leading creditor nation of the world. But cheap money policies would later create a slower consumption rate at home, rising land prices and the creation of an asset bubble that would burst years later that led to the period for Japan known as the lost decade.

Japan's recovery today from its lost decade is still very questionable due to the price of its currency. This may be the reason why currency prices today target inflation as a means to gauge growth policies rather than some arbitrary target as was set with the Plaza Accords. (To learn more, see The Lost Decade: Lessons From Japan's Real Estate Crisis.)